Fire Your Active Mutual Fund Manager!

by: Plan B Economics

Many investment funds are actively managed with the view that research and analysis will enable a portfolio manager to outperform the market.

Is active portfolio management really worth the expense (about 1-2%, depending on your fee structure) of owning a mutual fund? Or is it just a bunch of marketing hype? Should investors simply buy an S&P 500 Index ETF (NYSEARCA:SPY) with a 0.09% expense ratio and call it a day?

Here's the basic case for active management:

1. Manager can shift to cash to protect from downside

2. Manager can exploit security pricing inefficiencies

3. Manager can rebalance and reallocate across asset classes, sectors and geographies, depending on the mandate

If done correctly, the profit potential from active management is massive. This is why about $24 trillion globally is invested in mutual funds (Source: ICI 2012 Factbook). Everyone is looking to outperform.

Of course, not everyone can outperform the market. Being an average of all component returns, some investments must underperform the market and some must outperform the market. So right out of the gate, the case for active management becomes a race against probabilities.

Already, the case for active management doesn't seem to hold water. I'll let Eugene Fama and Kenneth French explain further:

The aggregate portfolio of U.S. equity mutual funds is close to the market portfolio, but the high costs of active management show up intact as lower returns to investors. Bootstrap simulations suggest that few funds produce benchmark adjusted expected returns sufficient to cover their costs. If we add back the costs in expense ratios, there is evidence of inferior and superior performance (non-zero true alpha) in the extreme tails of the cross section of mutual fund alpha estimates.(Fama, Eugene F. and French, Kenneth R., Luck Versus Skill in the Cross Section of Mutual Fund Returns (December 14, 2009).)

While they concluded that investment managers generally can't cover their costs, Fama and French allude to the possibility that some managers do in fact provide a positive alpha. So can one find such a manager?

Proponents of active management point to Peter Lynch, Bill Miller and Warren Buffett as their proof that it is possible to consistently outperform. These are highly regarded investment managers with a long track record of outperformance. However, out of the thousands of portfolio managers in the United States, there is a statistical probability that a handful will outperform many years in a row. Consequently, consistent outperformance does not necessarily equate to manager skill.

Moreover, even if some managers do consistently outperform due to skill, how does one select a future Warren Buffett? Many major mutual fund companies and brokerages have teams of analysts that spend careers researching, interviewing, analyzing and selecting investment managers to add to or fire from their platforms. If anyone was going to find the next Warren Buffett it would be these teams.

The reality is that fund platforms overseen by dedicated manager research teams, in my opinion, still contain many funds managed by mediocre portfolio managers. In fact, fund platforms overseen by dedicated manager research teams still experience their share of blow-ups, epic failures and dogs. If a 24/7 team of analysts with unprecedented access can't pick the next Warren Buffett, who can?

The final question to ask is whether investors who use active managers are in fact getting what they pay for. Many mutual funds are simply over-charging beta plays. They may either look very similar to a standard benchmark (e.g. S&P 500) or some combination of benchmarks. Beta is easy and cheap to get. A mutual fund that simply hugs some combination of indices won't outperform those indices. In fact, it should underperfom by the expense ratio. Worse, a fund that charges for active management and simply walks and talks like an index (less fees) is, in my opinion, ripping off its shareholders.

In today's world there's no need to chase an impossible dream or pay for something that simply isn't delivered. Using a handful of core ETFs, with the help of a financial advisor most investors can fire their active mutual fund managers and construct a diversified, inexpensive portfolio that provides beta exposure to whatever index desired.

Below I have listed a range of popular core ETFs used to provide exposure to broad asset classes. While there are numerous other core and niche ETFs to choose from, these should be enough to get started on an inexpensive core portfolio.

1. SPDR S&P 500 (SPY) - expense ratio of 0.09%

Description: The index measures the performance of the large capitalization sector of the U.S. equity market.

2. iShares Dow Jones Select Dividend Index Fund (NYSEARCA:DVY) - expense ratio of 0.40%

Description: The index screens stocks by dividend per share growth rate, dividend payout percentage rate, and average daily dollar trading volume, and stocks are selected based on dividend yield.

3. Vanguard Emerging Markets ETF (NYSEARCA:VWO) - expense ratio of 0.20%

Description: The index measures the performance of the emerging market stocks.

4. iShares MSCI EAFE Index ETF (NYSEARCA:EFA) - expense ratio of 0.34%

Description: The index measures the performance of equity markets in European, Australasian, and Far Eastern markets.

5. iShares iBoxx Investment Grade Corporate Bond Fund (NYSEARCA:LQD) - expense ratio of 0.15%

Description: The index measures the performance of 600 highly liquid investment grade corporate bonds.

6. iShares iBoxx High Yield Corporate Bond Fund (NYSEARCA:HYG) - expense ratio of 0.50%

Description: The index is designed to provide a broad representation of the U.S. dollar-denominated high yield liquid corporate bond market.

7. iShares Barclays TIPS Bond Fund (NYSEARCA:TIP) - expense ratio of 0.20%

Description: The index includes all publicly issued, U.S. Treasury inflation-protected securities that have at least one year remaining to maturity, are rated investment grade, and have $250 million or more of outstanding face value.

8. iShares Barclays 20 Year Treasury Bond Fund (NYSEARCA:TLT) - expense ratio of 0.15%

Description: The index measures the performance of U.S. Treasury securities that have a remaining maturity of at least 20 years.

9. Vanguard Total Bond Market ETF (NYSEARCA:BND) - expense ratio of 0.10%

Description: The index measures the performance of the U.S. investment grade bond market.

10. SPDR Gold Trust (NYSEARCA:GLD) - expense ratio of 0.40%

Description: This ETF is designed to track the spot price of gold bullion

11. iShares Silver Trust (NYSEARCA:SLV) - expense ratio of 0.50%

Description: This ETF is designed to track the spot price of silver bullion

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This is not advice. While the author makes every effort to provide high quality information, the information is not guaranteed to be accurate and should not be relied on. Investing involves risk and you could lose all your money. Consult a professional advisor before making any investing decisions.

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